Taxing future income to pay for college

How to pay for the seemingly inexorable rise in the cost of college tuition? One idea seems to be having something of a heyday right now: since college graduates earn more money, why not levy a tax on them which will pay for the cost of their education? After all, that’s what Australia has done for years, with reasonable success.

The Australian system is a loan: you essentially borrow the cost of tuition, and then repay it, with interest, through your income tax payments. Once you’ve repaid the loan, no more tax is due. The alternative is some kind of straight graduate tax, as proposed in the UK, Oregon, and, now, by Neel Kashkari in California. Although Kashkari’s proposal doesn’t go into any detail, he does say that he wants to offer “four-year college students majoring in a STEM field free tuition in exchange for a small interest in their future earnings”.

Kashkari is restricting his proposal to STEM students (those in science, technology, engineering, and mathematics), he says, “to address the potential adverse selection problem”: he doesn’t want a bunch of lazy arts students taking advantage of free tuition and paying back almost nothing from their negligible future salaries. Still, Kashkari’s proposal would be voluntary, so any engineer likely to have substantial earnings after college would rationally avoid the scheme. Instead, it would make much more sense for, say, a botanist planning on spending her career in the field, getting by on grants, post-doc stipends, and the like. Adverse selection works within disciplines just as much as it works across them.

In principle, I’m OK with the idea of graduates paying a slightly higher tax rate than non-graduates. Graduates are in many different ways the “better half” of society: richer, healthier, and generally the people who have got the most out of society, rather than those who have been failed by it. As such, it’s reasonable to ask them to share some of their good fortune with society more generally. But if we are going to have a graduate tax, it should be universal, and it should — like all taxes — be compulsory. The very idea of a voluntary tax is a bit silly, and, as Kashkari says, opens itself up to all manner of adverse-selection problems.

A graduate tax would not be a particularly effective way to tackle problems with education costs. If anything, it would only enable those costs to rise even higher. In general, the cost of college rises to the point at which the pips squeak: universities are becoming increasingly adept at charging just about everybody the absolute maximum they can pay. (This explains why rack-rate tuition charges are going stratospheric: the rich can and will pay through the nose for their education, while everybody else gets a “discount” which is carefully calibrated to bring the cost of tuition down barely into the realm of affordability.) If colleges suddenly found themselves with access to a new stream of income from a graduate tax, they would surely just start raising their tuition rates so that students would still have to take out loans to go to college — even after the government had paid the college from the new funds. Even if tuition were paid for in full, students would still need to find a way to pay for textbooks, room and board, transportation, and other costs. Already, tuition and fees amount to only about 40% of the costs of attending a state college; that percentage could easily fall further.

On top of that, a graduate surtax — even if it was limited to a certain number of years after graduation — would almost certainly end up costing most students more money, over the long term, than current tuition does.

A voluntary tax, however, would take all of these problems and severely exacerbate them — it would enable colleges to charge poor people much more than they currently can, and it would force a massive cost onto anybody unable to pay tuition up-front. Essentially, it would be a highly regressive tax — one paid only by the poor and never by the rich. (Think about it this way: if you could reduce your lifetime tax rate by two or three percentage points, at age 18, for an up-front cost of $50,000, or even $100,000, would you do so? You might well, if you were rich. That’s essentially the deal being offered here, only instead of paying to reduce your tax rate, you’re paying to avoid raising it.)

One version of the voluntary tax is a bit more interesting — the fully private version. The most advanced version of this deal is offered by Upstart: once you have a decent degree, you can then monetize it immediately, by pledging some percentage of your future income in return for an up-front payment. I’ve been skeptical of the Upfront model in the past, but I like it more now, partly because the term has come down from 10 years to 5 years. If this is a private tax, it’s one which doesn’t last much longer than college itself. What’s more, Upstart now offers all students a choice: you can either go down the income-share route, or else you can take out a more traditional loan, with a fixed interest rate.

In both cases, the underwriting process is the same, and operates on an individual, case-by-case basis, rather than broadly, in the manner of a government-levied tax.

There are problems with private taxes, of course. For one thing, unlike public taxes, they’re not tax-deductible: you still have to pay state and federal income tax on your gross income, even though some percentage of that gross income is going to flow straight out to Upstart. And that’s not the end of your tax liability. Upstart sells itself as offering downside protection: if you end up earning very little, you don’t need to pay back the full amount you were given up front. But you are very likely to need to pay income tax on it: the Upstart agreement positively shouts that “ANY SHORTFALL BETWEEN THE FUNDING AMOUNT YOU RECEIVED AND YOUR TOTAL PAYMENTS WILL BE REPORTED BY US AS INCOME TO YOU”. In other words, if you don’t pay back more than you were funded for, you’re going to end up paying income tax on money you were given at least five years ago. Which could be unpleasant.

You’re also likely to pay a substantial sum for that downside protection. Upstart reckons that investors in its platform are going to realize pretty healthy annualized returns, across a diversified base of students — significantly higher than typical interest rates on student loans. Which means that the typical student taking advantage of Upstart’s offer will end up paying more than they would if they’d just stuck to traditional loans: in order to think that you’re getting a bargain, you have to believe that you’re going to be below-average in terms of future salary. Still, there can be good reasons to take the offer all the same. For instance, if you spend a couple of years on some labor of love which pays little or nothing, Upstart will simply defer your obligation, while a student-loan lender will not be nearly as forgiving. (The deferment helps the investor too, of course, who would rather wait for you to start earning real money, and thereby get a higher net return on her investment.)

The fact is, however, that paying for college, either before or after you graduate, by paying a fixed percentage of your future income — well, it’s always going to be a niche thing. As far as the mainstream questions about paying for college are concerned, the CFPB has an excellent guide to the traditional choices. Which should exhaust the possibilities for 99% of students.

The fact that Upstart has launched a loan product is telling: it’s a lot easier to sell debt, rather than equity, to institutional investors, who look at Upstart more for its underwriting technology than as a way of trying to disrupt the way we pay for education. (Upstart reckons that it has a comparative advantage in the loans-to-graduates space: it has a pretty good idea of how much they’re likely to be earning, while most lenders, looking at a blank credit report, will refuse to lend at any rate.)

That’s why Marco Rubio’s proposed bill is very likely to go nowhere. It’s a very aggressive piece of legislation: it allows these contracts to run up to a full 30 years, for instance; it pre-empts the rights of any state to regulate such contracts; and it makes all payments under such contracts “not includable” as a part of your gross income for tax purposes. Basically, Rubio seems to want to be able to privatize the ability to tax individuals for decades at a time, and turn what is currently a clear prerogative of the state into a simple contractual matter between citizens and corporations.

Even putting Rubio’s craziness to one side, however, the idea of a surtax on graduates — even if it’s implemented by the state — is hard to implement, and raises various other problems to boot. For instance: what happens with college dropouts? Do they have to pay the surtax for the years they went to college, even if they’re statistically worse off than high-school graduates? In general, do we really want to tax the one thing that pretty much everybody agrees we need more of?

More broadly still, there are always ethical problems associated with the idea of buying and selling human beings — or even small percentage shares of them. (That’s one reason, I’m sure, why Upstart will let you buy a small share of a graduate, but won’t let you sell that share to anybody else.) The dreadful Fantex shares are up and running now, but I still hope and expect that Fantex will fail. Upstart I think has a brighter future — but probably more in loans than in income-share agreements. And as for state-levied graduate taxes, be they in Oregon, California, or anywhere else, I think we’re still a very long way from them actually being implemented. Especially given the broad opposition they’ve already managed to elicit.